Question

Brooks Clinic is considering investing in new heart-monitoring equipment. It has two options. Option A would have an initial lower cost but would require a significant expenditure for rebuilding after 4 years. Option B would require no rebuilding expenditure, but its maintenance costs would be higher. Since the Option B machine is of initial higher quality, it is expected to have a salvage value at the end of its useful life. The following estimates were made of the cash flows. The company’s cost of capital is 6%. Option A Option B Initial cost $183,000 $267,000 Annual cash inflows $72,800 $80,300 Annual cash outflows $29,200 $26,200 Cost to rebuild (end of year 4) $51,800 $0 Salvage value $0 $7,000 Estimated useful life 7 years 7 years Click here to view the factor table.

Your answer is partially correct. Try again. Compute the (1) net present value, (2) profitability index, and (3) internal rate of return for each option. (Hint: To solve for internal rate of return, experiment with alternative discount rates to arrive at a net present value of zero.) (If the net present value is negative, use either a negative sign preceding the number eg -45 or parentheses eg (45). Round answers for present value and IRR to 0 decimal places, e.g. 125 and round profitability index to 2 decimal places, e.g. 12.50. For calculation purposes, use 5 decimal places as displayed in the factor table provided.) Net Present Value Profitability Index Internal Rate of Return Option A $ 183000 8.95 9% Option B $ 270000 9.66 10

Answer 1

	Net Present Value	Profitability Index	IRR
Option A	$19362	1.11	9%
Option B	$39662	1.15	10%

(1) Net Present Value :-

(Net cash Inflow [PVAF 6%, 7 years]) – (Cost of rebuild [PVIF 6%, 4th year]) – Initial cost + Salvage (PVIF 6%, 7th year)

PVAF 6%, 7 years = 5.58238

PVIF 6%, 4th year = 0.79209

PVIF 6%, 7th year = 0.66506

Option A :-

Net Cash inflow = $72800 - $29200 = $43600

($43600 * 5.58238) – ($51800 * 0.79209) - $183000 + 0

   = $19362

Option B :-

Net cash inflow = $80300 - $26200 = $54100

($54100 * 5.58238) - $0 - $267000 + ($7000 * 0.66506)

= $39662

(2) Profitability Index :-

Present Value of future cash flows/Initial Investment

Option A :-

Present Value of future cash flows = ($43600 * 5.58238) – ($51800 * 0.79209) = $202362

$202362/$183000 = 1.11

Option B :-

Present Value of future cash flows = ($54100 * 5.58238) + ($7000 * 0.66506) = $306662

$306662/$267000 = 1.15

(3) Internal Rate of Return :-

Option A :-

Initial Investment = (Net cash Inflow [PVAF 6%, 7 years]) – (Cost of rebuild [PVIF 6%, 4th year])

$183000 = ($43600 * [PVAF 7 years]) – ($51800 * [PVIF 4th year])

At 9%:-

PVAF 9%, 7 years = 5.03295

PVIF 9%, 4th year = 0.70843

$183000 = ($43600 * 5.03295) – ($51800 * 0.70843)

$183000 = $182740

Hence IRR approx = 9%

Option B :-

Initial cost = (Net cash Inflow [PVAF 6%, 7 years]) + Salvage (PVIF 6%, 7th year)

$267000 = ($54100 * PVAF) + ($7000 * PVIF)

At 10%

PVAF 10%, 7 years = 4.86842

PVIF 10%, 7th year = 0.51316

$267000 = ($54100 * 4.86842) + ($7000 * 0.51316)

$267000 = $266974

Hence IRR approx = 10%